The DSL network relies on traditional telephone line and is often categorized as ‘legacy’ assets. It repurposes the telephone copper pairs to run internet data traffic. The number of customers relying on these legacy assets are shrinking at mid-single digits annually. It is being cannibalized by newer technologies such as cable, fiber, and wireless.

Attempting to track what a wireline categorizes as legacy is often misleading. The definition of what is deemed legacy has changed several times. One way to think of legacy is circuits that are incapable of speeds greater than 10Mbps download. This minimum speed threshold is what changes, which is why defining it is difficult.

It is important to recognize that the switch between technologies (DSL/cable/fiber) occurs slowly over many decades. As a parallel, one can look at why mainframe computers and dial up connections are still being used today. It is unlikely that in the near future DSL will go away. Rather, much of DSL services that presently exists will likely not go away. Cable companies have likely already explored the opportunity to expand into these regions housing traditional telephone lines, but have purposely decided against it because the economics are not justified. As a result, many regions will be bound to DSL technologies for the foreseeable future. This should be factored accordingly when modelling future DSL sales.

Additionally, there are technologies like fiber-to-the-node which extends the lifespan of older DSL technologies. It does so by mixing DSL technology with fiber technology (creating a DSL/fiber hybrid network). Performance of DSL improves by an order of magnitude as a result. These investments are high return on investment as you’re replacing only a few centralized equipment running on better optics and algorithms, while getting speed benefits across the board. We touch more on this topic in the section on Fiber Supply vs. Demand.

Finally, much of the share in DSL has already been eroded from faster cable technology, especially in the residential environment. This is why most telcos’ DSL technology serves the enterprise segment, while cable takes the lion share of the consumer market.

Appendix H: Introduction to Fiber Landscape

Fiber optics offers much higher throughput (download/upload speed) and more importantly, better latency than coaxial cable (cable) or copper pair (DSL). The benefits in throughput are slightly more obvious but the benefits in latency will appear more obvious in the years to come. Applications such as virtual reality and virtual web conferencing will catalyze its relevance.

Fiber providers have been around for a long time but not well-known to consumers because their target customers are predominately service providers and enterprises. Some of the pure play fiber providers include Level 3 Communications (expected to be acquired by CenturyLink), Zayo, Cogent, and GTT.

These pure fiber providers offer two types of products. The first is known as IP Transit. If an individual wanted to connect to google.com, he/she would purchase an internet connection from the local provider. The local internet provider receives this request to connect to google.com but needs internet services itself in order to reach this website. The local internet provider purchases what is called IP Transit to connect to the rest of the internet.

The second product sold by pure fiber providers are very high speed internet circuits to enterprises. This is similar to regular internet connections for consumers but at higher speeds, security, and reliability. Some of the names of these business-grade internet connections are MPLS, VPLS, EPL, and EVPL.

These fiber providers compete with the local telcos and cablecos to provide fiber to enterprise customers. Fiber providers, telcos, and cablecos target enterprises in multi-unit dwelling or locations where there are many potential customers. This is due to the high capital requirement of the initial build out. The potential return laying a single fiber to a building of a hundred residents is much higher than a fiber to a single resident.

The major distinction between the pure fiber providers (think Cogent and Zayo) and the telcos/cablecos is their geographical focus and target customers. Telcos/cablecos focus on a local region and target both enterprises and consumers. On the other hand, pure fiber providers choose to target service providers and enterprises, not consumers. They have strategically chosen to build a highly-distributed network spanning across states, as oppose to building regional density. Interestingly, this approach after a decade appears to have been highly successful in breaking into the wireline market.

Appendix I: Fiber Economics: Bandwidth Demand vs. Pricing Pressure

For over a decade, we have seen dramatic decreases in the cost of IP transit (bandwidth). Rates have been decreasing around 20% annually ($/Mbps) for the past five years, while the prior five years have ranged from 50-90% decrease year-over-year. One might speculate that at a certain point it would be uneconomical to sell IP transit. However, that would be incorrect.

Cogent’s IP Transit business (previously disclosed as their ‘Net Centric’ segment) has been able to grown at mid-high single digits for the past five years. This occurred even as Cogent decreased their rates approximately 20% annually. If one were to aggregate Cogent’s total pipe size, which represents how much traffic could be pushed through their total network at any given moment, this pipe has been growing at about 30% annually for the past 4 years.

Regardless of what the future holds for pure play fiber providers like Cogent, one could say they have already succeeded. For one, they have correctly identified the business model to enter the wireline market which has a strong defendable moat (see Competitive Advantage). They hold assets which allow for a regionally-concentrated peer to expand to have national presence.

Driving the cost of bandwidth down is the continued improvements in algorithms, optics, spectrum optimization and more. On the demand side, we have devices like smartphones, servers, and PCs. It is however, the demand for content-richness and number of devices that have been causing demand to outpace supply. Much of the long-term value of fiber rests on this equilibrium. We will explore this supply and demand balance in the next section.

Appendix J: Fiber Supply vs. Demand

Will we have too much supply – hindering the long-term value of fiber? Is the supply created by wireless providers a substitute for the supply of fiber wireline? Will wireless replace wireline?

First let’s look at the supply side. It is important to first recognize much of the wireless network itself is fiber. Between the cellular towers is fiber built and managed by wireline providers. Wireline providers add supply by installing more fiber optic cables in conjunction with utilizing higher performing network equipment. Wireless providers add supply by relying on wireless network gear and spectrum. Supply grows linearly as more fiber is laid, and cell towers are built. However, exponential growth comes from innovations in optics and algorithms. The critical question is therefore considering the potential for improvements in algorithms and technology. We think about this in two ways,

Moore’s Law – defining the improvement in computing speed (# of transistors on a chip will double every 18 months)

Shannon’s Law – defining the maximum network speed (theoretical speed data can transfer given power and noise)

More significantly, technology improvements are not realized and implemented as quickly as they are discovered. There are delays in when the industry collectively decides to upgrade to the newer technology. An estimate lifecycle to refresh to a newer technology is about 5 years. Cellular speeds, for example, require chip manufacturers, policy-makers, regional wireless carriers, and more parties, to collectively work together to build and roll out the technology. Networks will lag behind devices because of the challenges relating to planning and implementation. Looking out 10 years from now, we should see 2-4x increase in supply created by these algorithmic/technological improvements.

Another opportunity for increasing supply is through spectrum optimization. Current communication devices mainly crowd around the 500MHz – 3GHz bands. Ten years from now, the spectrum availability should double, contributing to a 2x improvement in supply. Summarizing the supply side, we should see 4x, 6x or 8x improvement in the next 10 years due to improvements in such things like algorithms and spectrum.

On the demand-side, demand is primarily driven by [i] content richness and [ii] number of broadband devices. There has been a constant evolution of devices: phone, mp3 player, tablets, laptops, IP-based TV, HD TV, and Ultra HD TV. The bandwidth demand for each of these newer devices are growing at exponential rates. Nielsen’s law estimates bandwidth demand doubles to residential homes every 24 months. The demand for content richness in combination with the number of devices approximates to a 100x increase in the demand over the next decade.

To summarize, wireless is not a substitute for wireline, rather, connected technologies. The situation in which wireless could be a substitute for wireline is if bandwidth requirements remained low – ie. devices aren’t demanding more bandwidth. Ten years from now, we will see an increase in the supply. However, supply will grow in the ball park of 10x (rounding upwards). Demand side looks to increase by a 100x, greatly outpacing the available supply. The solution to the supply-demand imbalance will unlikely be a slowdown in data consumption or number of devices. Rather, wireline and wireless providers will be working together to add more supply. At the core, the network will be all fiber. At the edges, there will be a vast array of wireless technologies such as: macro cells (miles), micro cells (300m), pico cells (100m), WiFi (30m). In the near term, wireline providers will hint at this supply/demand imbalance through usage-based billing. In conjunction, wireless providers will implement rate plans (50GB, 100GB, 500GB).

It would be favorable in extracting profits if wireline/wireless carriers could maintain control of the full vertical stack, from the data pipes to the content. The past decade has proven to be challenging for the traditional vertically integrated models in telecommunications. Carriers have recognized the complexities in various niches of the vertical and have divested assets like data centers and towers assets. Niches along the vertical have emerged such as IP Transit and Content Delivery Networks. Over-the-top offerings like Netflix continue to be a topic of concern.

Below we will look at the past, present, and future industry structure. We will question whether the wireline/wireless industry is horizontally- or vertically-integrated. We will look at the past and the present to propose what to expect in the near-future. We will consider if the environment will be more or less favorable for wireline carriers. We will also suggest that a pragmatic strategy for wireline firms is to align with the industry structure.

The state of the wireline/wireless industry has parallels to the computer industry. The computer industry went through a shift from a vertical structure to horizontal structure. In the early days, it made a lot of sense to be vertically integrated. Computer components required a high degree of technical integration and firms like IBM offered a lot of value by integrating the complexity. Today, the computer industry is very different. Most of the traditional computer companies have broken apart and have been sold off.

Professor Charles Fine describes the industry structure as something that does not remain constant, but rather gradually cycles between a vertical structure and a horizontal structure.

Over the past few decades, the telecom industry has matured and flattened. This movement from a vertical to horizontal structure is consistent with modular service-oriented software architecture which has been increasingly more relevant. In the prior vertical architecture, there were a number forces pushing it towards a horizontal and modular configuration. These included,

The challenge of managing many different operating segments across the many dimensions of technology, required by an integral system. Traditional operators had to manage data centers, cell towers, manage hosted applications, facilitate wholesale access into their networks, and more.

The challenge of fending off the entry of niche competitors hoping to pick off discrete industry segments. Niches such as Content Delivery Networks and IP Transit providers required a different distributed business model. This business model was in direct contrast to traditional telcos that built their moat around regional dominance.

The bureaucratic and organizational rigidities that often settle upon large, established companies.

Although we believe the wireline industry and the larger telecom sector will continue to horizontally integrate, it is worth considering the driving forces for vertical integration which will eventually occur. These forces include,

Technical advances in one subsystem can make that the scarce commodity in the chain, giving market power to its owner. At this present time, we don’t see such advances like this that exist.

Market power in one subsystem encourages engineering integration with other subsystems to develop proprietary integral solutions. We also see little evidence of this in traditional wireline and wireless carriers.

Market power in one subsystem encourages bundling with other subsystems to increase control and add more value. This perhaps is the most relevant factor that has some merits of truth. We believe wireline providers will be able to successfully deliver TV but not control the content itself.

Analysis of the industry structure helps to design and validate the business model. If an individual wireline carrier chooses to vertically integrate, is this consistent with the overall industry? If not, what is the method in which they plan to lower costs, facilitate scheduling and planning, facilitate investments in specialized assets? Conversely, if the wireline carrier chooses to horizontally integrate, there are a few key requirements for success. We will see these are consistent with the wireline thesis and favorable to Cincinnati Bell. They include,

Reduction in Competitive Intensity

In a consolidated industry, there is typically higher probability for high sustainable profitability.

Similar to pharmaceutical companies, wireline carriers have a shared sales, marketing, and support team which amount to a large fixed cost.

On the operations side, regional economies of scale comes from the elimination of duplicate network infrastructure such as data centers, cross connections, and IP transit.

Operating expenses are further minimized through having smaller network operation centers managing a larger number of network elements.

Access to New Markets and Distribution Channels

Kraft’s acquisition of Cadbury created access and distribution into India, Egypt, Thailand, and Latin America.

Similarly, larger wireline carriers looking to expand into new markets will likely need to acquire regional providers as oppose to building out their own network.

In the next section, we will chronologically step through some key historical events in history of US Telecom. We believe it supports the strategy Cincinnati Bell is undertaking, which reflects a sound management team. We also think it supports the idea that Cincinnati Bell will eventually be purchased.

During this period, people subscribed to multiple vertically integrated providers (represented by the vertical bars below). Technology at this time was relatively new and there was a need to reduce complexity for the average consumer.

1934 – 1982 (~50yrs) Communications Act: One big vertical

Government gives AT&T monopolistic rights.

1982 – 1996 (~14yrs): DOJ splits up AT&T

In 1984, AT&T was split to 7 x Regional Bell Operating Companies (RBOC) while AT&T retains control over Long Distance and Bell Labs.

This new structure solved the complexity of connecting the many independent providers, while also relinquishing AT&T’s control.

This was also the initial pressure to horizontally integrate (vertically disintegrate) although structure was still highly vertical and continued to be vertical till around 2000.

Wireless divisions spun off and joined together. PacTel, USWest, and Bell Atlantic became Verizon in 2000.

Interexchange Carriers (IEXs) competed against AT&T’s long distance service, and integrated with Internet backbone providers to become the long-haul networks of the future. Late 1990’s gave rise to many new long-distance carriers such as Global Crossing, Qwest, Level-3, and Frontier. However, AT&T and MCI/Worldcom still controlled most of the market, combining for 82% (1999).

2000 – 2010: Niche Entries to Serve Discrete Industry Segments

Firms like GTT selected a niche of providing back-bone services (IP Transit), then grew horizontally within this niche.

Wireless carriers like T Mobile choose to sell off (and instead leases) its cell towers. It chose to take on one niche in the vertical (customer service) and horizontally growing from there.

The wireline industry is broken down between cable, fiber, and digital subscriber line (DSL). Each of these offer the same service of delivering an internet connection through a physical wired medium. They differ in terms of the type of physical medium, underlying technology, and costs economics.

DSL is the oldest technology. It runs off telephone copper pairs and owned by the traditional telephone companies – think CenturyLink or AT&T. Cable came after, and runs over coaxial cable, allowing for better download/upload speeds – think Charter or Comcast. Fiber is the newest, which brings fiber optics right to the customer’s premises. Fiber offers the potential for orders of magnitude improvement in speeds, will cost less to maintain, but still early in its product adoption for consumers.

In terms of market share, cable is well in the lead and will remain so for years to come. The table below summarizes the results. In general, cable is taking share from DSL, and fiber is taking share from cable. This trend will continue.

The industry is characterized for its oligopolistic nature. In each geography there is typically two providers with large stable market share. This dynamic is not a phenomenon but due to the high capital nature of the business. Once a company invests the capital to lay out the infrastructure, there is a big disincentive to duplicate that investment. In rural areas, investments often need to be subsidized by tax payers in order to proceed. An example is the Connect America Fund (CAF-II), where 10 telecommunications carriers will receive nearly $9bn in subsidizes over 6 years to buildout broadband to 23 million Americans. After this build out is completed, the probability for a second entrant, not subsidized by tax payers and with less financial strength, is unlikely. Aside from the financial hurdles, there are additional barriers such as gathering the rights-of-way, and risk the incumbent will lower the price after the build out is complete. All in all, this creates the existence of competitive advantage with return on invested capital in the mid-teens.

Appendix B: Industry Map

Wireline providers service two categories of customers: enterprises and consumers. The above diagram shows the map for the enterprise customer, which is slightly more complex than the consumer diagram. The enterprise diagram provides more insight on the dynamics of a typical wireline provider.

The above diagram breaks the Wireline Carrier and IT Services as two separate components. However, they both fall under one corporate entity. The separation is to show the functional differences of these separate departments.

Wireline providers have a specific division, referred to as IT Services, whose focus is on serving enterprise customers. Businesses often demand more than just an internet connection. They need a VoIP phone system, cloud hosting, a secured network, and additional network reliability. IT Services can be thought of as an integrator of IT services, but not a manufacture of the underlying products. As an integrator, IT services often needs to purchase routers from Cisco, phones from Polycom, PBX systems from Broadsoft, and hosting from a local data center.

The key ingredient used in all IT services is the physical internet pipe. This could be fiber, cable, DSL or perhaps wireless. Building this physical network is the core of wireline providers, represented as Wireline Carrier in the above diagram. Wireline providers whose network is based on DSL technology are referred to as Telcos. Wireline providers whose network is based on cable technology are referred to as Cablecos. Worth noting, there is fiber built into both DSL and cable networks. For example, DSL telcos would extend fiber optics to a street corner, then rely on copper pair between the street corner to the customer’s home (referred to as the “last mile”). True end-to-end fiber extends the fiber right to the customer’s home.

Wireline providers traditionally owned the data centers but recently have been divesting these assets to focus only on their core wireline business. Although we have listed Data Center and IP Transit Providers in this map, it by no means a holistic view. It is meant to show how and where, in general, these partners connect to the Service Provider (Wireline Carrier).

In the consumer segment, customers generally call the wireline provider directly or alternatively order services online. Consumer requirements are less complex, often requiring only a single internet connection. The simplicity is why consumers can interact directly with the wireline provider as oppose to an IT Service integrator.

Wireline providers rely on purchasing three primary ingredients: fiber, switches, and routers. Switching and routing hardware vendors include names such as Alcatel-Lucent, Adtran, Juniper, and Cisco. In general, the buyer/seller relationship does not favor the hardware vendor or the Specialty Contractors. We will discuss this further in our section on Competitive Advantage.

Appendix C: Competitive Advantage

There are three drivers which have and should continue to ensure the steady profitability of wireline carriers: a one-to-many relationship with its supplier and customers, a track record of disciplined rivalry, and economies of scale. A good starting point in understanding how the industry works (who’s retaining the profits), is by looking along the industry map, and considering each pair of relationships. The relationship between,

Wireline Carriers vs. Contractors

Wireline Carriers vs. Hardware Vendors

Wireline Carrier vs. Enterprises Customers

Wireline carriers have a one-to-many relationship both as a buyer and a supplier. This has structurally allowed them to capture more value as a buyer, while simultaneously charging more from their customers. Across the United States, there are many wireline carriers. However, there is typically only one or two that control each state. Local enterprises often have no choice for alternatives and must accept the price and service that is offered. This effect is magnified in rural communities where on occasion service interruptions span for weeks with no recourse. As improvements in speeds are offered, they typically come hand-in-hand with price hikes.

Their relationship with contractors and hardware vendors is one of the same story. Regional carriers are typically not in competition with one another, rather operate with high degree of coordination. This is possible due to mature product offering in a homogenous industry. Collectively they decide when upgrade cycles occur, and control this final buying decision. As an example, north of the border, one of the main wireline providers intelligently chose to defer their fiber investment by nearly a decade.

The second factor driving profitability is the level of rivalry. How fiercely do firms compete with one another along dimensions such as price, service, new product introductions, promotion, and advertising?

Historically, there has been little rivalry due to the oligopolistic structure of the wireline industry. Rather, there has been high degree of tacit coordination amongst peers in regards to upgrade cycles, service offerings, and pricing. Example of such is coordination between wireless and wireline carriers include,

The allowance to form bundled products using each other services for better customer lock-ins

Of the variables influencing the degree of rivalry, incumbents are in a very favorable position in terms of concentration (Herfindahl-Hirschman Index > 1000), homogeneity (very similar corporate philosophies and common goals), and demand variability (given product maturity).

The third factor driving steady profitability is regional economies of scale. To a greater extend, Cincinnati Bell benefits from this scale beyond its wireline peers. It does so because it has a concentrated geographic footprint. Unlike some of its peers, it has strategically maintained a contiguous footprint. CBB is able to capitalize on this by having a dense fleet of wireline technicians and support staff that can support local customers. Its concentrated footprint allows it to efficiently deploy sales and marketing. For example, an advertisement targeting CBB’s entire footprint would be meaningfully more efficient than that of a national peer.

Additionally, the economics required to justify an investment in their Fioptics network is more favorable with greater customer density. For example, how much potential sales can be spread across the fixed costs of the planned network? How much can we oversubscribe? How quickly can we reach a cost breakeven? All of these favors a denser network footprint.

Appendix D: Wireline Business Model

The value proposition of a wireline carriers is one of delivering simple, reliable, internet, television, and phone services in a bundled package. The revenue streams are through a monthly subscription for access to the internet/television/phone network. There is typically two separate customer segments: wholesale and retail. Wholesale caters to businesses and other service providers, while retail focuses on consumers. Customer relationships are driven by acquisition strategies involving the bundling of internet, TV, and phone services. The retention of customers are motivated by increasing speeds, and in turn increasing the average revenue per customer (ARPU). The primary channels to connect with customers are through local call centers and online portals.

On the expense side – the cost structure is driven by building out, supporting, and maintaining its network, in addition to sales and marketing expenses. It key partners are various contractors who build out the physical wireline infrastructure and network architects who build out the digital network that rides on top. Key activities include monitoring and maintaining the reliability of the network, and scaling it up as needed. Finally, the key resources are around its physical wireline network, in conjunction to the financial resources required to fund the continued maintenance and expansion of this capital-heavy endeavor.

In 1Q17 Lumos Networks was acquired by EQT Infrastructure. Lumos had three business segments: Data, R&SB, and RLEC Access. Roughly, their Data is “strategic” assets, while R&SB is closer to “legacy” DSL technology including PRI, long distance and analog lines. RLEC is something in between, some valuable, some not so much. One approximate way to categorize and normalize its assets mix is as such:

Above, Lumos’ Data segment is renamed Strategic, R&SB renamed Legacy, and RLEC split between the two. The blue values are inputs while the black font are calculations. We start by using the acquisition price of approx. $900mm and assume an EV/EBITDA multiple of 4x on Legacy assets. The goal is to calculate the implied EBITDA and Sales multiples of Lumos’ Strategic and Legacy assets. By assuming a 4x EBITDA multiple on Legacy, it implies a 12x EBITDA multiple on Strategic assets. Lowering the 4x EV/EBITDA multiple on Legacy would increase the multiple on Strategic, and vice versa. Next, we will look at additional wireline peer multiples to validate our Lumos analysis, in addition to getting a better sense of the rest of the wireline carriers.

Before thinking about the current multiples, we will categorize the types of wireline carriers as seen above. For example, it is worthwhile separating wireline carriers with a cable assets versus copper assets. The EV/EBITDA of 4x for Lumos’ Legacy is lower than the average as we believe copper DSL will continue to come under heavy pressure in the next few years. Directionally, it should come down and not up, however, feel free to adjust as you see fit. We used peer multiples and chose a ‘base multiple’ representing what we feel would be conservative. For example, Frontier trades around 5x EBITDA but we feel 4x is more reasonable. These base multiples will then be applied to Cincinnati Bell as comparison. As a sanity check, we looked at recent wireline acquisitions such as CenturyLink’s acquisition of Level 3 (13x+ EBITDA), Windstream’s acquisition of Earthlink (~5x EBITDA), and Consolidated Communication’s acquisition of Fairpoint (~6x EBITDA).

For Cincinnati Bell, we applied our base multiples of 12x EV/EBITDA on Strategic and 4x EV/EBITDA on Legacy. The results imply a price per share of $22.38. However, there are a few other observations,

Both Strategic and Legacy use a multiple we think are conservative.

EV/Sales of Legacy imply DSL sales may cut in half. We don’t think it will be that extreme but we will use this in a separate valuation model below.

Additionally, we should discuss how we are approximating Strategic and Legacy sales for Cincinnati Bell.

CBB currently reports approx. $660mm of “strategic” revenue in the last 12 months

What is defined “strategic” by wireline carriers is based on speed capabilities. This definition unfortunately changes. The trend is faster speeds which is why the definition changes. Given that a number of wireline firms re-categorize “strategic”, we don’t think it’s fair to trust this definition.

We will instead define CBB’s strategic assets as only: Fioptics, Unified Communication, and a small portion (5%) of their DSL network. These totals $360mm which is almost half of the reported $660mm. $240mm to Fioptics (excluding Voice), $80mm to Unified Communication, and $40mm to DSL.

Finally, the EBITDA Margin can be approximated in a few ways. We consider CBB’s current margins, peer margins, its relative strength versus technologies like cable long-term, etc. The below table shows historical margins. What isn’t shown below is the implied EBITDA margin in the terminal years based on current valuations. This terminal average margin for cable and fiber carriers is around 40%.

This analysis point to nice downside protection from the current price. Next, we will look at a 10yr unlevered free cash flow.

Assumptions in the above model include,

Discount rate of 6%

0-1% top line growth until maturity

-1% maturity growth rate at year 10 and on

Minimal gross margin improvement. This is conservative considering the cost structure of a fiber network is lower than a DSL network and meaningfully lower than managing a DSL and fiber network.

Terminal EBITDA margin of 30% which we think represents a meaningful amount of conservativism relative to cable peers.

As a quick sanity check of the Discounted Cash Flow,

This valuation also arrives at the same conclusion that there is upside at the current price while applied to what we think are conservative assumptions. We however feel this traditional method of valuation is not appropriate given the industry is in a consolidation phase. As discussed in Appendix E: Revisiting the Computer Industry, we suspect a continued pattern of natural consolidation and inorganic growth. This makes modeling based on historic growth quite unrealistic. We believe CBB will either grow through acquisitions or be acquired in the long-run. It therefore makes more sense to only model for the next few years.

Over the next few years, we believe fiber demand will remain strong and likely accelerate. However, it is Cincinnati Bell’s cash availability that will limit their fiber investment. We estimate Cash Flow from Operations to remain around $150-200mm over the next few years. This assumes around $20-25mm annual restructuring and $40mm working capital. At this level of cash generation, we anticipate new fiber buildout will slow relative to the past few years. Legacy DSL will continue accelerate downwards while Unified Communication and IT Services will grow. Three year from now, the thesis is essentially an asset-mix swap from legacy to fiber. The below model follows our above ‘legacy’ definition and margin assumptions. We think there is safety even using conservative assumptions such as,

Fioptics EBITDA multiple and margins remain at current levels although it continues to grow

We should begin by segmenting the opportunities for growth. A logical way is simply following how Cincinnati Bell segments its business: Consumer and Enterprise. Additionally, we should simplify by only focusing on growth from its core business of providing internet services.

Should Cincinnati Bell grow its consumer internet organically or through acquisitions?

Should Cincinnati Bell grow its enterprise internet organically or through acquisitions?

Of these four opportunities, which is of priority? Which would be most pragmatic?

Currently, cablecos hold the majority of share in the consumer segment. Telcos on the other hand have good reach to enterprises because they run off the historic telephone copper network. Like cable in its early days, fiber optics is now being pushed to the consumer segment and gaining share. This should happen quite organically due to the superiority in technology. The enterprise segment should at the same time become more competitive.

We think it would be pragmatic to organically grow the consumer segment. There isn’t a need to aggressively grow this through acquisitions, which could further disturb the competitive environment. On the other hand, it is worthwhile for Cincinnati Bell to invest and more aggressively defend its enterprise segment. Breaking down the enterprise segment, there is two sub-components: internet and IT Services (eg. VoIP, network security, hosting). Let’s review our industry map.

The Enterprise Customer is looking for an internet connection, Unified Communication, network security, and hosting. It engages a Service Provider for this packaged solution. The Service Provider acts as an integrator, leasing the internet circuit from the local carrier (in some cases, its competitor). There are two paths in investing to boost the enterprise business,

Directly – through focusing efforts on the Service Provider (IT Services)

Indirectly – through investing in the wireline infrastructure (which local Service Providers will in turn purchase for Enterprise Customers)

We think it would be most pragmatic to focus efforts firstly on the Service Provider who services the Enterprises. In the case of Cincinnati Bell, this would mean focusing on building that enterprise relationship first, even if they do not own any wireline infrastructure in service area. This could mean having to lease the underlying wireline infrastructure from a competitor to service the end-customer. This offers a key ancillary benefit. Over time, the fiber wireline infrastructure can be built to the end-customer, knowing they already have the relationship in place. When the fiber arrives, the existing cable circuit can be cancelled. This is the approach Cincinnati Bell is taking to expand its footprint into Michigan.

PART VI: RISKS

The wireline competitive landscape has weighed heavily on DSL carriers over the past year and we believe this will continue for the next few years. As DSL continues to lose share, there is a compounding effect because the costs of supporting the infrastructure do not symmetrically move downwards. Measures such as augmenting the DSL network with fiber (Fiber-to-the-Node) will help, yet these improvements still struggle to compete with cable speeds. In our next section on Valuation, we redefine what we believe to be true Legacy assets. We think it will take about three years until CBB’s Fioptics business surpasses ‘legacy’ as a percentage of total sales. As such, a reasonable argument is to wait. This disproportion negative emphasis on DSL legacy assets could continue. The rebuttal is that with high probability the competitive landscape will subside. At that time, the less noticeable fiber assets will be proportionally valued.

The risk in turn shifts to the robustness of fiber growth. Categorically, the concerns are either [i] a disagreement on a macro supply-demand for fiber assets in the future, or [ii] Cincinnati Bell’s ability to build out their fiber network. The first concern we discuss in Appendix J: Fiber Supply vs. Demand. The second concern we briefly discuss in the following section on Valuation. This concern relates to whether CBB will have sufficient cash to continue its fiber build out. Not currently issuing a dividend to its common shareholders puts them in a good position. This contrasts with names like Frontier who has had to cut their dividend. The immense importance of maintaining this dividend policy is difficult to describe. For those interested, we recommend reading in on Telus quarterly conference calls. As Entwistle describes, everything that relates to financial engineering is in servitude to their dividend growth model – their top priority. Regardless, it is highly recommended to follow Telus’ quarterly commentary as Entwistle is likely the most articulate and formidable competitor in the telecom space.

In Cincinnati Bell’s case, we would closely monitor its cash availability to pay down debt, in addition to investing in its fiber network. Any sudden movement in its leverage ratio would justify a reassessment of our short-term thesis. This quandary has been weighing on firms like CenturyLink as they are also trying to build out their fiber network. Over the past few quarters, their capital has been able to fulfil their dividend quite effortlessly. However, looking holistically, it has fallen short in improving its capital structure.

PART VII: CATALYST/ENTRY

Our three-year timeframe is in line with the 2020 target for 5G technology. Over the past few years there has been skepticism around high frequency mmWave spectrum and its application in 5G technology. The latest bidding war for Straightpath hopefully settles this debate. In the world of 5G, the demand for new fiber is a prerequisite for the technology to come to fruition.

The fiber thesis and catalyst follows the same logic of mmWave spectrum. That is, the catalyst are typically events that validate the demand for the spectrum or fiber asset. How will fiber/spectrum technology play a role (if any) in the future? Some of these catalyst in spectrum included,

The Federal Communications Commission (FCC) publishing a Notice of Inquiry (NOI) in October 2014, in which they sought comments on several bands as potential for 5G

The FCC confirming StraightPath’s high frequency bands are of value by fining them for hording it

Verizon acquisition of XO Communication’s spectrum

AT&T intention to buy FiberTower’s spectrum and cell backhaul network

Technical reports from Samsung, Qualcomm and other vendors validating their adoption of the technology utilizing the high frequency bands.

In the present environment, wireline remains highly competitive with carriers offering significant improvements in speed at little to no cost. One could make the argument that an optimal entry point is during these competitive environments when uncertainty is most prevalent. Unfortunately, determining this slowdown in competition likely unknowable. What we do know is that historically the industry has been known for its tacit coordination and lack of direct price competition. The likelihood that the price wars will persist for more than three years seems unlikely. As the competitive landscape decelerates and CBB’s fiber reach scale, they have the option of instituting a dividend.

IT Services and Hardware – IT services such as cloud hosting, VoIP phones, network security, etc.

Within Entertainment and Communication (E&C), it is further segmented into:

Consumer – bundled internet and TV packages offered to consumers

Enterprise – internet services to businesses

Carrier – leasing of internet pipes to wireless carriers

Simplistically, one can think of the Entertainment & Communication segment as TV and internet, and the IT Services are the additional services such as VoIP phones (that run on that internet circuit). In considering asset value, it is more informative segmenting Cincinnati Bell in terms of its technologies (DSL vs. Fiber), as oppose to their consumer or enterprise segments.

In Appendix G, we include an Introduction to Digital Subscriber Line Landscape for those want some background. We think the current wave of subscribers switching from DSL to cable is both very real and will likely accelerate in the near-term. However, this switch in technology will take longer than expected and DSL assets will continue to have value over the next 5-10years. When the value in Cincinnati Bell’s DSL assets start to stabilize, the focus shifts to its fiber assets.

We offer a brief Introduction into the Fiber Landscape in Appendix H. We take a deeper dive into this by looking at Cogent, a pure play fiber provider in Appendix I. Over the past decade, the cost of bandwidth has been coming down at staggering rates. This called into question the sustainability of firms like Cogent. Thus far, many have been surprised of the robustness of demand. We think this trend will continue to prove the skeptics wrong.

In Appendix J: Fiber Supply vs. Demand, we take a longer-term view and propose where we think supply and demand will be a decade from now. Here we conclude that wireless is not a substitute technology to fiber, but rather connected technologies. A decade from now we expect technology could have as much as a 10x multiplying effect on the supply. However, demand will vastly outpace the supply, driven by content richness and the number of devices. This idea is core to our thesis.

PART IV: CINCINNATI BELL’S FIBER BUILD OUT

A transformative fiber optic networks is in progress. Over the past few years, Cincinnati Bell has spent around half a billion dollars in building out its “Fioptics” fiber network. This Fioptics investment represents a significant amount relative to their size. As a percent of their Property Plant & Equipment, it is approximately 50%. This contrasts with CenturyLink which is less than 20%, assuming a similar weighting of fiber to maintenance capital expenditures.

Fioptics sales have been growing at a nice 30%+ annually and its contribution to total sales have more than doubled. This sales figure however is misleading. It is a poor representation of the longevity of its future cash flows. The earning potential of the fiber assets should increase for the next decade but will remain useful even further. Currently, cable has taken the majority share of residential internet due to its technical superiority. Fiber is and will continue to offer a path back into the residential market.

“The business case for FTTP has improved dramatically over the past few years, with costs falling significantly. Ten years ago, Verizon’s cost to deploy FTTP was roughly $1,500 per home passed, plus another $1,500 per home to connect. Cincinnati Bell and CenturyLink have recently estimated the cost per home passed at $500–700, almost one-third of what it used to be.” (Ovum)

A better metric for Cincinnati Bell’s Fioptics success is their subscriber count. Over the past few years CBB has been able to grow subscribers at around 25%+ y/y versus the national fiber average about 15% y/y (4% broadband subscriber growth y/y). Looking into the near-future, the cost of deploying fiber will continue to come down, while the addressable market will continue to expand.

In Ohio, Indiana, and Kentucky, fiber penetration rates are low relative to the national average. This offers favorable opportunities for organic growth.

“Passing” measures how many potential customers the fiber network exposes CBB to. For example, if you owned the fiber assets along a street with 20 homes, your “passing” would be 20. CBB’s passing has expanded from 276 thousand homes at the end of 2013 to 533 thousand homes at the end of 2016. Additionally, the number of Fioptic internet subscribers relative to the Total Passing has been improving every quarter. What is important to note here is absent an investment in new construction, growth can come from increasing penetration.

In thinking about the long-term margins of fiber, we can use Cable as a lower bound benchmark. Most cable providers are around the forty percent EBITDA margin at maturity. This margin assumption is also consistent with the valuation built into pure fiber providers like Cogent. However, it would be wise to exercise some caution on margin potential looking into the future. Specifically, as the industry evolves into a more horizontal structure, competition should drive margins down. This is further discussed in the section on Industry Structure. Additionally, CBB’s primary competitor in the cable space is Time Warner Cable (now owned by Charter Communications), and run by a true visionary that needs no introduction.

Finally, it is worth considering how fiber deployment has played out historically. How did fiber compete vs. cable in 2007? Looking at Net Subscriber Adds between 2007 and 2012, it is clear cable ‘net subscriber adds’ beats out DSL’s ‘net subscriber adds’ during the same quarter. However, when Telcos added video (bundled in a Fiber offering), it consistently beats out cable. We are seeing this pattern reoccur now and probable to assume it will continue into the near-future. To further emphasize, this does not even consider the benefits of latency that fiber offers because the use cases have not yet emerged.

For those looking for a more complete analysis, we have included Appendix A:Overview of Wireline Industry. Here we introduce the competing technologies, the number of subscribers per technology, and its relative market share.

In Appendix B:Industry Map, we take a high-level view of the industry and look at how the various parties exchange product/services with one another. It is not meant to be exhaustive, but rather to set to stage in [i] explaining why competitive advantage exist and, [ii] to propose what we think is a pragmatic growth strategy.

We follow the industry map with a look at the sources of competitive advantage that exist in the wireline industry (Appendix C). Despite the escalated competitive environment, it is worth noting these key sources that drive steady profitability remains intact.

The above table shows various wireline providers in the United States. It is in no way a rigorous list but provides a quick sense of various players, their relative sizes, sales and margins. The first observation worth noting is Cincinnati Bell’s relative size. Although it appears relatively small and may lack scale advantages, this is not the case. In actuality, its concentrated presence in Ohio, Indiana and Kentucky gives it more scale economics than larger peers in the context of its own states. This can be seen from its more efficient operating expenses.

The second observation is the relative multiples appropriately reflect maturity and growth potential of the technologies. Telcos predominately own copper DSL technology and are attempting to grow their fiber network. Cablecos predominately own coaxial cable technology with a hybrid fiber/coax network. IP Transit providers are predominately fiber. One part of any telco wireline thesis relates to the probability they can transition from their legacy copper network to a fiber network. Moving on, we will very briefly glance over some multiples of Telus, a Canadian telco/wireless carrier.

Although this is not an apples-to-apples comparison, it offers what we feel is a good relative sense of the industry. You will want to model out a dozen wireline peers yourself, but the general characteristics of this industry can be seen using Telus as an example. Note, you would have to adjusted accordingly given Telus’ dominant wireless assets. Having built a base-line sense of the industry, we will shift focus back to Cincinnati Bell and look at how it’s different from its peers. We will start by looking at Cincinnati Bell’s recovery efforts over the past 5-years.

Over the past few years Cincinnati Bell has been patiently deleveraging its balance sheet from 5.2x Net Debt / EBITDA in 2012 down to 4.2x in 2016. One key event was the sale of its wireless segment to Verizon in 2014, which was bleeding cash. More notably was its gradual sale of CyrusOne which completed in the first quarter of 2017. To provide some context, this data center business grew revenue from $74mm in 2009 to $529mm by the end of 2016.

We think the recent changes have positioned it to have a more natural equity investor base. Specifically, its debt pay down, 1-to-5 reverse split in 3Q 2016, diversification of non-core assets for easier understanding of business segments, and option to institute a dividend. Additionally, its balance sheet has gradually improved. Expenses have been eliminated around its wireless segment, pension obligations, and maintenance from legacy copper operations.

We think Cincinnati Bell is positioned favorably in a horizontal market. Counter to AT&T’s strategy to vertically integrate, we believe the industry is and should be moving horizontally. The industry is in a multi-decade cycle to break apart vertically with niche verticals such as: data centers, IP transits, content delivery networks, tower operators, communication platform providers, security platforms, and various OTT offerings. For a firm operating in a dynamic vertically integrated market like Salesforce.com, top line growth is important. The firm with more resources will more likely create that fully-integrated solution. We want our CRM to be fully integrated to connect our sales department to support department. We want all data centralized and marketing and analytics already tied into the same system. The opposite is true for a firm operating in a horizontal maturing market with low growth like wireline. In a horizontal maturing market, we would like to see non-core assets diversified, and an opportunity to be easily acquired. If not acquired, we want to see the firm positioned to compete well against peers because it holds regional scale advantages. We want the firm to have relatively newer fiber technologies, while also having nimbleness in relative size. These two factors will help it navigate the future of SD-WAN, IP Elastic cores, OTT, and more.

For those looking for a deeper dive into the industry structure, we have a section titled Revisiting the Computer Industry included in Appendix E. Here we look at how the telecom industry has matured and why it is flattening in a horizontal structure. We discuss what the requirements are in order to succeed in such a structure, and Cincinnati Bell’s alignment to this. We end off by proposing how we think the near-future will look and why we think Cincinnati Bell will be acquired.